Section 199 Domestic Production Deduction – New IRS Proposed Regulations – Contract Manufacturing

One area of dispute for many years under the Section 199 Domestic Production Activities Deduction was in situations where the taxpayer designs a product but a third party contract manufacturer actually produces the product under contract with the taxpayer. Prior to these new proposed regulations issued in August 2015, the benefits and burdens of ownership tests/criteria would be applied to determine which party can claim the Section 199 deduction. In many cases, activities of the taxpayer in coming up with the product, design, development, testing, package design and other activities could be included and in cases where the taxpayer met a number of the benefits and burdens of ownership during the contract manufacturing process, the taxpayer could claim all of the product revenues as qualified for Section 199 purposes.

The IRS has been struggling with administration of this issue for some time, and the prior iteration involved guidance from the IRS seeking to have the taxpayer and contract manufacture agree to who has the benefits and burdens of ownership and sign a statement indicating which taxpayer will claim the Section 199 Domestic Production Activities Deduction. See October 29, 2013 LB&I Control No. LB&I-04-1013-008.

Now under the controversial new proposed regulations, the IRS is taking a stance that only the contract manufacturer can claim the Section 199 deduction in that it’s the final party to actually produce the product. This is true even if the taxpayer has substantial activities in developing, designing, patenting, testing, prototyping the product in-house with only the final stage being a production run by a contracted company. This also is pretty typical industry norm across many industries in using contract manufacturers. So the new regulations essentially say in the thousands of contract manufacturing industries, the taxpayer who develops, owns and distributes the product cannot claim any of that net income as Section 199 eligible income, whereas the contact manufacturer can claim their profit or markup as 199 revenue for producing that product.

In our view, and the view of many companies who develop and sell products, this seems to go against the intent of the Section 199 rationale for awarding a deduction for companies retaining product development activities in the U.S. and retaining those jobs. This would not only include factory line jobs, but product design, packaging design, QA/testing, manufacturing supervision, CAD design work, software development relating to product, and many other job types that are performed in the U.S. to produce a U.S. product. In our view, there would also be no overlap or double dipping (which the IRS seems concerned with) where the taxpayer claims a deduction on its net income from sales of its product, whereas the contract manufacturer can still claim a deduction for its markup profit in the manufacturing step of the process (these are two separate revenue streams). Rather, the new proposed Section 199 regulations strip out any product sales revenue for U.S. products if the taxpayer decides it doesn’t have the resources in-house to mass produce its products (which is the case with millions of U.S. businesses).

A hearing is scheduled at the IRS in December 2015 with regards to these new Section 199 regulations and the contract manufacturing portion of the regs should be the most interesting part of that hearing.

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